Cover Story: Tracking Stocks: Do They Create Value? Although they’ve been around for 15 years, the jury is still out on whether they are viable techniques for shareholder value enhancement.

On April 27, a landmark was reached with the public offering of AT&T Wireless Group Inc. By generating proceeds in excess of $10 billion, it was the largest IPO ever floated. But the issue that gave investors a play in the wireless telecommunications operations of AT&T Corp. had another notable aspect. AT&T Wireless is a tracking stock – the curious and highly controversial hybrid in which the parent company retains actual ownership of the business while public investors trade the shares. For the experts who have debated the merits of tracking stocks for a decade-and-a-half, the ATT Wireless issue had the potential to be a watershed event in the development of shareholder value, corporate restructuring, and strategic planning techniques. The presence of AT&T as the primary sponsor, some argued, stamped a blue-chip endorsement on tracking stocks, taking them out of the experimental category and comforting other large companies with plans to segment their relatively diverse operations. Indeed, at least nine other companies have tracking stocks in the works, either through IPOs or tax-free spin-offs. However, the lackluster aftermarket performance of AT&T Wireless hasn’t done much to prompt other companies to break the ice or to quiet the debate. In early June, the shares were trading on the New York Stock Exchange at just under 29, compared with the IPO price of 29.50, with a range of 24-3/8 to 36. Conversely, there have been success stories, notably the performance of another wireless telecom operation – Sprint PCS, which was spun off by Sprint Corp. in 1998. Hitting the market at around 20, Sprint PCS was trading on the Big Board in early June at more than 55. Because of the checkered pattern of stock market results exemplified by the divergent experiences of AT&T Wireless and Sprint PCS, the jury is still out on whether tracking stocks are viable techniques for creating value. There have been a few wins but a number of setbacks and no consistent explanation for the mix. The evidence is also scanty, moreover, because there just haven’t been many tracking stocks – 20 at most since they first appeared in the mid-1980s as acquisition currencies used by General Motors Corp. to buy Electronic Data Systems Corp. (EDS) and Hughes Electronics Corp. And they have been spread over a number of industries, although recent issues and proposals have been largely connected to technology areas, such as Internet retailing and services and biotechnology, as well as wireless phones. The theory behind the tracking stock is that it separates a supposedly “hot property” from a company’s core business, allowing the unit to gain a public valuation from investors that should be reflected in the parent company’s overall value. The parent retains control of the assets and the earnings stream. If the business is profitable, dividends can be paid to shareholders based on its earnings stream. Critics contend that the tracking stock concept is too complex for many investors to understand and does not provide the ultimate pure play that can be fashioned from a spin-off or IPO carve-out. Many also believe that some of businesses represented by tracking stocks are poor candidates for pushing the envelope. They also point out that several companies that originally issued tracking stocks became disenchanted and either redeemed the issues or made significant revisions. Proponents argue that the concept of continued control and public evaluation is a good one and will get a better test when the population of tracking stocks grows. But both sides warn that the tracking stock is not for every situation. Bill Frack, a vice president of L.E.K. Consulting who has studied both the performance and the strategic efficacy of tracking stocks, says that they are good approaches in limited situations, depending on the nature of the business and its place within the parent corporation. He recommends that the restructuring-minded company go through a careful analysis in which it weighs strategic, competitive, valuation, and other factors and compares them with the pros and cons of alternatives strategies, such as spin-offs and IPO carve-outs (see Table 1). For example, the tracking-stock approach allows the parent and the sub to continue sharing assets but may result in a duplication of administrative costs. In the financial area, Frack said, the tracking stock can expose a unit with volatile earnings or outright losses for a parent with rather stable earnings. As a result, it is not unusual to see tracking stocks in high-tech businesses that haven’t earned any money yet. Both AT&T Wireless and Sprint PCS, for example, are still in the red. The issue, Frack noted, is that the stock market values the parent’s core business and “star” subsidiary by different metrics. “The reality is that there are businesses for which the predominant valuation method is top line rather than bottom line,” Frack said. “The top line could include unit sales, or number of subscribers, or it could be actual revenues. For all of these businesses that are underwater today but are expected to have a certain profitability in the future, there is an inclination, albeit a risky one, to use top-line multiples to get some handle on the potential of the business.” He added that as long as investors continue to value the separated business on a top-line multiple, “the theory is that there shouldn’t be a motivation to divest.” Valuation differentials gave rise to the creation of tracking stocks – then called “letter stocks” by GM – as acquisition currencies. GM, with its auto businesses maturing, set out to diversify through acquisition but sought some type of approach to capture the loftier valuations accorded the faster-growing, higher-technology companies that it was buying. That led to the issuance of separate stocks – the E stock for computer services firm EDS and the H stock for the aerospace and communications giant Hughes, whose earnings have been prone to fluctuation. Letter or tracking stocks have never been used as acquisition currencies since, but they have emerged as restructuring vehicles via IPOs and spin-offs – mostly in the late 1990s. The track record for the handful of tracking stock IPOs, all with Internet connections, floated in recent years has not been a happy one. Car Max Group, the used car merchant taken public by retailer Circuit City Stores Inc., was trading at just over 3 in early June compared with a February 1997 IPO price of 20. DLJ Direct, the online brokerage arm of Donald Lufkin & Jenrette Securities, went public at 20 in May 1999 but was selling at around 9 in early June. ZDNet Group, the Internet information arm of Ziff-Davis Inc., had dropped to around 11 from a March 1999 IPO price of 19. All are traded on the Big Board. Spin-off activity picked up in 1999, led by moves by two Big Board companies – PE Corp. and Quantum Corp. – to split their businesses into tracking stocks. PE issued separate classes for Celera Genomics, a biomedical and genomic information company, and PE Biosystems, a manufacturer of analytical instruments. Quantum issued separate stocks for its DLT & Storage Systems Group, a maker of information storage systems, and Hard Drive Disk Group, a disk drive manufacturer. Liberty Media, a cable programming company, was originally spun out as a tracking stock by Tele-Communications Inc. (TCI) in 1998 and kept as a tracking stock by AT&T when the company acquired TV cable systems owner TCI the following year. Liberty was trading at nearly 56 in early June and has been considered among the more rewarding tracking stocks. Outside of the technology field, Georgia Pacific Corp. spun out its Timber Group as a tracking stock in 1997 in a move to separate its forest products business from its manufacturing operations. The group’s stock was selling at around 23 in early June. Besides the disappointing performances for many issues, tracking stock watchers are disquieted by the considerable number of revisions and retirements that have punctuated the development of the trend. In the latest high-profile move, GM executed a share swap that cut its economic interest – its share of earnings – in Hughes to around 32% from 68.5%. Hughes remained a tracking stock but GM lessened the impact of the satellite communications firm’s bottom-line volatility. Hughes is currently in the red. Many GM shareholders traded their stock for shares of Hughes in a tax-free exchange that also reduced the number of GM shares outstanding. AT&T also intends to reduce its economic interest in AT&T Wireless. Meanwhile, Ziff-Davis is planning a restructuring that will change ZDNet from a tracking stock to the main issue of the company. As part of the plan, Ziff-Davis, which sold its computer magazine operations in 1999, is spinning off its computer trade show business. As a result, ZDNet will survive as a pure play in Web-distributed technology content, commerce, and services. Two other companies had second thoughts about their tracking stocks and eliminated them. Michigan utility CMS Energy Corp. in 1999 redeemed its G stock, which had been sold publicly in 1995 to represent large parts of its business. And Pittston Co. earlier this year “recombined” the tracking stocks it had out for its transportation and security businesses, leaving the firm with one common issue. Pittston plans to continue its restructuring by selling its coal mining operations and focusing on transportation and security as its primary businesses. And the deal that started the whole idea of tracking stocks – GM’s acquisition of EDS – was taken apart in 1996 when the two parted company through a spin-off that relaunched the computer services firm as an independent company. EDS’s technologies and capabilities had graduated dramatically from the time of the acquisition in 1984 in response to demands from the marketplace. GM’s continued ownership of EDS had become unwieldy for both firms, and cutting it loose was deemed the better way to go. But the beat is going on. Du Pont Co. has disclosed plans to issue a tracking stock for its life sciences business, thus separating its growing health care business from its huge chemicals and fibers operations. Cablevision Systems Corp. intends to float an IPO for a company that will house its cable channels and other entertainment operations to separate them from its cable TV systems. In mainstream retailing, J.C. Penney Co. registered a tracking stock IPO for its Eckerd drug store chain. Other filings with an Internet connection include Cendant Corp. for its Move.com relocation, real estate, and home-related services portal; Staples Inc. for its Staples.com operation; and New York Times Co. for its Times Co. Digital business. Given the inconsistent, often rude market treatment for tracking stocks, there is no advance indication of how these proposed issues will perform, or whether they will even see the light of day. However, Frack said that despite the absence of a pattern in tracking stock performance, he has been able to draw a series of rationales for creating publicly traded businesses under that rubric through spin-offs or IPOs. Frack calls them the “five points of light.” They embrace not only valuation issues but strategy, finance, and management incentives and include: Financing – Selling a tracking stock to the public is “an effective way to raise cash.” “All management teams like to have more money to play with,” Frack stated. In this case, the public would be ponying up considerable sums to finance the growth of the business represented by the tracking stock. Valuation – “Often, there is a value recognition play,” Frack noted. This is influenced by whether there are different ways of valuing parts of an overall company, such as the aforementioned “top-line” view of technology-based or emerging operations. “Sprint wireless is a wonderful wireless business, and the company was able to separate it from the its core long-distance business,” Frack said. Management Incentives – This is an often-overlooked aspect of the tracking stock decision. The tracking stock can be used to reward executives for successful management of the growth or “star” business, especially at a time when there is a heavy demand for top-flight people from all kinds of technology businesses, including the dot-coms. “It primarily has to do with compensation and retention,” Frack said. “The business being carved out has more upside potential than the parent. That is a very strong motivation, because people can go elsewhere. In the case of Sprint’s management, the company was able to monetize their knowledge of the wireless business. “For corporate management, it’s a tool to retain these people. It’s an equity component that is real and it’s located at the business unit rather than the corporation.” Structure – According to Frack, the tracking stock may be easier to accomplish than a spin-off or carve-out in terms of establishing a “financial track record” and separating or sharing assets and resources. For example, the parent and the tracking business can continue to share common functions or resources. “If you are going through a carve-out or a spin-out, it’s essential to establish a stand-alone company,” Frack remarks. “That requires both financial documentation and operational development. Let us say that the company has leveraged a number of corporate functions. Now you have to go through a process of disaggregating them. With the track stock, if you are carving out an earnings stream notionally, it requires less time to execute and less operational hassle.” Control – The corporate management doesn’t give up control of the business represented by the tracking stock, which may be its “hottest property.” Internet or wireless businesses again emerge as primary examples. “In today’s market, that’s the reality of what these businesses are,” Frack said. “That’s often the sex appeal of these businesses, both from a market sizzle and a valuation sizzle standpoint. It’s hard for overall corporate management to give that up.”